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How do you know that there is a bubble in the marketplace for U.S. Treasuries and other "safe" bond investments? The answer begins with a definition of what a "bubble" is. A "bubble" is a situation where investors purchase an asset under the following conditions:

(1) Investors believe the price of the asset will rise more than, or retain value better than, other assets, for the foreseen future;

(2) Investors suspect the price of the asset may ultimately drop, but believe they can exit the investment at an opportune moment and avoid losses; and

(3) Investors ignore historical pricing of the asset, believing instead that current market conditions represent a fundamental paradigm shift.

Condition (1) - high expectations for the relative safety of Treasuries. Several commentators have argued that U.S. Treasuries are not in a bubble because few investors expect to earn outsized returns by investing in Treasuries. That argument fails to account for the fact that returns are, ultimately, entirely relative. The investor who is convinced the value of all assets besides Treasuries will collapse, while the value of the Treasuries themselves remain constant, is no different than an investor who is convinced that the value of a particular asset will skyrocketed relative to the value of other assets. A penny saved is exactly the same thing as a penny earned, so either way, both investors believe that they will come out ahead relative to other investors. In short, a widespread expectation in the marketplace of zero percent nominal risk-adjusted returns does not indicate there is no bubble in the marketplace for U.S. Treasuries. A widespread expectation that the price of stocks, real estate, commodities and other assets will decline while U.S. Treasuries provide the last safe haven standing, that is indicative of a bubble in the marketplace for U.S. Treasuries.

Condition (2) - investors are betting they can get out in time. Interest rates are at historic lows -- 1.6% today, the lowest interest rate in recorded history for U.S. government debt. What would happen to the value of a ten year Treasury if interest rates were to rise to 5%, which is still on the fairly low side of average interest rates on a ten year Treasury? The answer is that the nominal principal value of a ten year Treasury would fall by 30%. Now assume a 3% average annual inflation rate - a fairly typical inflation rate we see here in the U.S. Now we see the principal value of a ten year Treasury dropping by a stunning 50%.

Let's assume for the moment that investors on the whole are not stupid, and know how to run a time value of money computation. If so, then it's fairly clear that investors expect that the value of Treasuries could very well drop in the intermediate term -- by an enormous amount, in fact. So why would anyone invest in a ten year U.S. Treasury now, with upside risks capped at a 1.6% interest rate, and downside risks of a negative 50% return looming in the indeterminate future? The answer is that an investor like this must be assuming that he or she will be able to step out of the Treasury market just in time to avoid taking massive losses on the principal value of his or her portfolio. Bubbles create a false sense of security, marked by a widespread belief among investors that they will be smarter and more nimble than the rest.

Condition (3) - it's a new world out there. Maybe interest rates will remain at historic lows for the next decade, with inflation clocking in near zero. It's never happened before, but it could happen if we are in a new era where the old rules just don't apply anymore. There's plenty of reasons to suspect we are -- historic levels of government debt, a stagnant global economy, and so on. Maybe investors think it's different this time around, and they could prove to be correct. But that sort of thinking, once widespread, is another classic hallmark of a bubble.

I will leave it for the reader to decide for himself or herself whether U.S. Treasuries are in a bubble or not, but I'd urge investors to remember that whatever looks like a duck and quacks like a duck is, very likely, a duck.

Disclaimer: I am not an investment advisor. No reader should construe this article as investment advice, or rely on it when making investment decisions. The article states the author's viewpoints and is written for discussion purposes only.

Source: The Market For U.S. Treasuries Is In A Bubble